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Land of the rising yield curve

Posted on August 2, 2018

The Bank of Japan (BoJ) tweaked its Yield Curve Control (YCC) policy earlier this week in a move designed to enhance the sustainability of their easy monetary policy. In order to signal a prolonged period of low interest rates and to keep real yields low or negative, YCC anchored the nominal yield on the 10-year Japanese Government Bond (JGB) at 0% in September 2016, subject to a degree of fluctuation in a narrow (but unannounced) trading band widely thought to be +/- 10bps. Since then, the 10-year JGB has indeed stayed predominantly within a range of -10bps to +10bps, with the BoJ intervening to buy unlimited amounts of bonds to prevent yields from moving higher (it has never had to intervene to sell unlimited amounts of bonds to protect the lower bound). This week, the target for 10-year Japanese Government Bonds (JGBs) was kept at 0% but the trading band was allowed to widen from +/-10 bps to +/-20bps. With positive economic growth and an economy close to full employment, market focus had been on the lifting of the upper end of the band, given the negative side effects of low interest rates and a flat yield curve on banks’ profits. However the BoJ’s apparent willingness to allow slightly higher bond yields flies in the face of weakening inflation data. So why are they doing it and is this the beginning of monetary policy normalization and a sequence of hikes? First the fundamental background:

In their forecasts, expected growth for FY2018 was nudged marginally lower, from 1.6% to 1.5%. Growth forecasts for the next two financial years were left unchanged at 0.8% pa.

Of greater significance, their inflation forecast for this year was lowered from 1.3% to 1.1%, and for the longer term from 1.8% to 1.6%. The longer term downgrade was significant, given their 2% inflation objective which they are not going to meet during their forecast horizon.

These inflation forecasts, which have historically been off the mark, still look too optimistic to us with core inflation at only 0.2% (excluding fresh food and energy) and at 0% (excluding all food and energy).

The BoJ has been subject to intense lobbying from Japanese banks to raise the 10-year JGB target from 0% to allow them to earn a wider spread between the 0% that they pay on their bank deposits and the carry from owning 10-year (or longer) JGBs. But the BoJ could not simply succumb to bank pressure – lifting bond yields may contribute to yen strength, thereby hurting exports and, to the extent that higher bond yields feed through to the real economy, borrowers in general. Explicitly lifting the targeted 0% yield for 10-year JGBs would also be a communication nightmare for the BoJ, given weak inflation dynamics. Nevertheless, markets had been speculating on a BoJ move and this led to a recent rise in 10-year to 40-year JGB yields and some sympathetic rise in global bond yields (however it is difficult to disentangle last week’s rise in US bond yields from the response to the slight de-escalation of tariff tensions with the EU).

The BoJ squared the circle by:

Insisting that there was no fundamental change in their YCC policy but the tweaks were designed to enhance the sustainability of easy monetary policy.

The doubling of the fluctuation band to +/20bps for 10-year JGBs. This was designed to improve market functionality which had been impaired by low to no volatility in JGBs at that part of the curve.

Insisting that they did not tighten policy.

Using a wider band going forward will help to avoid problems for banks.

However allowing higher 10-year yields will also be data dependent.

What does all this mean for global government bonds?

Global Quantitative Easing (QE) and global cross border flows have and will keep UST term premium down (this is the extra compensation investors require to buy a long dated bond as opposed to a series of shorter dated bonds). The speculation that the BoJ would allow higher JGB yields probably contributed to higher US Treasuries yields over the past week. Notwithstanding short-term bouts of volatility as the markets test the resolve of the BoJ, we expect JGB yields to move marginally higher from here. In essence, the BoJ can succeed in putting 10-year JGB yields where they want them to be, as they already own up to 80% of some bond issues.

At some stage, the BoJ will have to confront the reality that although low bond yields and a flat yield curve hurt banks, these are mostly symptoms and not causes of slow growth and slow inflation. If anything, this week’s measures will encourage banks to put money into risk-free government bonds rather than lend to risky projects. The feared de-anchoring of JGB yields that will contribute to a global bear market in government bonds has been put off for at least some quarters, if not longer.

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